In economic theory, a moral hazard is a situation where a party will have a tendency to take risks because the costs that could incur will not be felt by the party taking the risk. In other words, it is a tendency to be more willing to take a risk, knowing that the potential costs and/or burdens of taking such risk will be borne, in whole or in part, by others. A moral hazard may occur where the actions of one party may change to the detriment of another after a financial transaction has taken place.
For example, with respect to the originators of subprime loans, many may have suspected that the borrowers would not be able to maintain payments and that, for this reason, the loans were not, in the long run, going to be worth much. Still, because there were many buyers of these loans (or of pools of these loans) willing to take on that risk, the originators did not concern themselves with the potential long-term consequences of making these loans. After selling the loans, the originators bore none of the risk so there was little to no incentive for the originators to investigate the long-term value of the loans. A party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party isolated from risk behaves differently from how it would if it were fully exposed to the risk.
Another, more complex, example would be the euro debt crisis, in which the troika of relief funds (aka the ECB, the IMF, and the EC) for heavily indebted nations like Greece are waiting as long as possible to act. The risks of a money run, and the consequential market crash in Europe is by far not as detrimental to these institutions as to the indebted nations themselves.
Moral hazard arises because an individual or institution does not take the full consequences and responsibilities of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to hold some responsibility for the consequences of those actions.
Economists explain moral hazard as a special case of information asymmetry, a situation in which one party in a transaction has more information than another. In particular, moral hazard may occur if a party that is insulated from risk has more information about its actions and intentions than the party paying for the negative consequences of the risk. More broadly, moral hazard occurs when the party with more information about its actions or intentions has a tendency or incentive to behave inappropriately from the perspective of the party with less information.
Moral hazard also arises in a principal–agent problem, where one party, called an agent, acts on behalf of another party, called the principal. The agent usually has more information about his or her actions or intentions than the principal does, because the principal usually cannot completely monitor the agent. The agent may have an incentive to act inappropriately (from the viewpoint of the principal) if the interests of the agent and the principal are not aligned.
Other articles related to "moral hazard":
... From a principal agent perspective, monetary policy makers face a personal moral hazard — since their compensation typically takes the form of a secure fixed annuity ... inversely related to the unemployment rate would create a moral hazard in favor of overly loose monetary policy ... wealth contingent on real GDP growth may be more efficient by reducing their overall moral hazard ...
... Some critics of the hedge fund industry claim that the compensation structure generate high fees for investment strategies that follow a Taleb distribution, creating moral hazard ... In such a scenario, the fund can claim high asset management and performance fees until they suddenly 'blow up', losing the investor significant sums of money and wiping out all the gains to the investor generated in previous periods however, the fund manager keeps all fees earned prior to the losses being incurred – and ends up enriching himself in the long run because he does not pay for his losses ...
... does not lead to adverse selection, but instead moral hazard, the situation where deliberate actions by one of the parties of the contract, after the ... This is the result of moral hazard, which creates what is termed in the literature as an agency cost, and can be thought of as arising from the benefit the ...
... Moral hazard problems also occur in employment relationships ... Moral hazard can occur when upper management is shielded from the consequences of poor decision making ... have some effective means to hold those responsible to account, moral hazard would be expected to continue to future building projects ...
... Further information Moral hazard A taxpayer-funded government bailout of financial institutions during the savings and loan crisis may have created a moral hazard and acted ...
Famous quotes containing the words hazard and/or moral:
“I, who am king of the matter I treat, and who owe an accounting for it to no one, do not for all that believe myself in all I write. I often hazard sallies of my mind which I mistrust.”
—Michel de Montaigne (15331592)
“The moral earth, too, is round! The moral earth, too, has its antipodes! The antipodes, too, have their right to exist! There is still another world to be discoveredand more than one! Set sail, you philosophers!”
—Friedrich Nietzsche (18441900)